Sweat Equity

Sweat equity refers to the value added by entrepreneurs in a new venture through their unpaid labor. It reflects the value created by the owners of a company as a result of the time, talent, and effort they contribute. The term "sweat equity" refers, in general, to the noncash contribution of an entrepreneur without a link to accounting.

However, in some countries entrepreneurs are able to account for their sweat equity in their balance sheet. Entrepreneurs can then receive additional share of ownership for their added value. In contrast to sweat equity, financial equity refers to the monetary contribution to a company by its owners.

In the context of a venture capital financing round the sweat equity of the entrepreneur may lead to conflicts in negotiating the deal. The entrepreneur and the venture capital investor are likely to have conflicting perspectives on the share of ownership the entrepreneur should keep due to his noncash contributions.

The entrepreneur expects to be compensated for the sweat equity he has contributed in the past. In contrast, venture capital investors base the venture valuation purely on the future growth potential. For them, it is relevant whether the past efforts of the entrepreneur result in a basis for future profits that would enable them to realize a successful exit.

Only then they would be willing to compensate the entrepreneur for his past efforts. Ineffective or irrelevant contributions by the entrepreneur can be considered sunk costs for the entrepreneur.